Analysis Of The Supreme Court’s Judgement In Yum Restaurant (Marketing) P. Ltd On The Doctrine Of Mutuality

In Yum! Restaurants (Marketing) Pvt Lrd vs. CIT, the Supreme Court has laid down important principles of law concerning the taxation of mutual associations. CAs Satyajeet Goel and Himanshu Aggarwal have conducted a detailed study of the judgement. They have systematically analyzed the judgement and identified all the core principles of law emanating from it

1. Doctrine of Mutuality

The doctrine of mutuality stems from basic principle that “a person cannot make profit from himself”. The foundation of this doctrine is well recognized and logical in a sense that element of commerciality is missing in transaction undertaken with oneself. For that reason, it is deemed in law that if the identity of the seller and the buyer is marked by one, then a profit motive cannot be attached to such a venture. Thus, for the lack of a profit motive, the excess of income over the expenditure or the “surplus” remaining in the hands of such a venture cannot be regarded as “income” taxable under the Act.  What is taxable under the Act is “income” or “profits” or “gains” as they accrue to a person in his dealings with other party or parties that do not share the same identity with the assessee. The vital elements of doctrine of mutuality has been reaffirmed and reiterated by Apex court in the landmark judgment in the case of Bangalore Club v. Commissioner of Income Tax & Anr (2013) 5 SCC 509.

This doctrine becomes relevant in the cases of collective associations formed for the mutual benefit of participating members and which should be left out from the target range of taxing statute due to absence of income ingredient.

However, the applicability of doctrine of mutuality has always remained a subject matter of litigation when applied on a given set of facts where the taxpayer seeks to dodge the rigour of taxation statute by forming associations or entering into arrangements ostensibly for mutual benefit of its members. In such circumstances, it becomes essential for the revenue authorities as well as courts to decipher the real intent and substance of the transaction on the touchstone of doctrine of mutuality vis-à-vis the written mandate of the association/arrangement so as to separate wheat from chaff.

The Hon’ble Supreme Court in the Union of India &Ors vs Playworld Electronics Pvt. Ltd. reported in1989 (3) SCC 181case observed that it is true that tax planning may be legitimate provided it is within the framework of the law, colorable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honorable to avoid the payment of tax by dubious methods.

Hon’ble Justice Chinnappa Reddy, in McDowell and Co. Ltd. v. Commercial Tax Officer, reported in [1985] 154 ITR 148, observed that it will be too much to expect the legislature to intervene and take care of every device and scheme to avoid taxation and it is up to the court sometimes to take stock to determine the nature of the new and sophisticated legal devices to avoid tax and to expose the devices for what they really are and to refuse to give judicial benediction.
Notably Lord Reid in Greenberg v. IRC, [1971] 47 TC 240(HL) held that one must find out the true nature of the transaction. It is unsafe to make bad laws out of hard facts and one should avoid subverting the rule of law.

2. Issue’s involved in the present case

The question involved was applicability of the doctrine of mutuality qua the assessee company, a fully owned subsidiary of Yum! Restaurants (India) Pvt. Ltd. (for short, “YRIPL”), formerly known as Tricon Restaurants India Pvt. Ltd., incorporated for undertaking the activities relating to Advertising, Marketing and Promotion (for short, “AMP activities”) for and on behalf of YRIPL and its franchisees.

3. Facts of the present case:

(a) The assessee company was incorporated by YRIPL after having obtained approval from the Secretariat for Industrial Assistance (SIA) for the purpose of economization of the cost of advertising and promotion of the franchisees as per their needs on the condition that it was obligated to operate on a non­profit basis on the principles of mutuality.

(b) Further, the Assessee entered into a Tripartite Operating Agreement with YRIPL and it’s franchisees as per which the Assessee received fixed contributions to the extent of 5% of gross sales for the proper conduct of the advertising, marketing and promotional activities for the mutual benefit of the parent company and the franchisees.

(c) The assessee filed its returns declaring “Nil” income under the pretext of the mutual character of the company.

(d) The AO rejected the Assessee’s contention and having regard to the clause 4.1 of the Tripartite Operating Agreement held that YRIPL was under no legal obligation to pay any amount of contribution as per its own version reflected from tripartite agreement.

(e) The CIT(A) colored the activities of the assessee to be in commercial nature and held ” In my opinion, taking an overall view of the intent and motive of the appellant company to form a ‘mutual concern’ it can be concluded that the underlying purpose was solely for commercial consideration. Therefore in view of the above as demonstrated by the appellant the excess of receipts over the expenditure i.e. the surplus in my opinion would be income liable to tax.”

(f) The ITAT held that the essential ingredients of the doctrine of mutuality were found to be missing by observing” it is seen that a part of contribution is also received from M/s Pepsi Foods Ltd. and YRIPL. Pepsi Foods Ltd.is neither a franchisee nor a beneficiary. Similarly some contribution is also received from YRIPL which YRIPL is not under any obligation topay. Thus it can be said that essential requirement that of the contributors to the common fund are either to participate in the surplus or they are beneficiaries of the contribution is missing. Through the common AMP activities no benefit accrues to Pepsi Food Ltd. or YRIPL. Accordingly the principles of mutuality cannot be applied.”

(g) The High Court held that “Pepsi Foods Ltd which do not benefit from the APM Activities. Moreover, the principle of mutuality is applicable to those entities whose activities are not tinged with commercial purpose. As a matter of fact in the instant case the parent company i.e., YRIPL which has also contributed to the brand fund is under the agreement under no obligation to do so. The contributions of YRIPL are at its own discretion. Thus, looking at thefacts obtaining in the present case, it is quite clear that the principle of mutuality would not be applicable to the instant case”

4. Question of Law formulated by the Hon’ble Court

(a) Whether the assessee company would qualify as a mutual concern in the eyes of   law,   thereby exempting subject transactions from tax liability?

(b) Whether the excess of income over expenditure in the hands of the assessee company is not taxable?

5. Assessee’s Arguments

A. The sole objective was to carry on the earmarked-activities on a non­profit basis and to operate strictly for the following benefit of the contributors to the mutual concern:
(a) Assessee levies no charge on the franchisees for carrying out the operations.

(b) YRIPL is the parent company of the assessee and earns fixed percentage from the franchisees by way of royalty. Thus, it benefits directly from enhanced sales as increased sales would translate into increased royalties.

(c) As regards Pepsi Foods Ltd., the franchisees were bound to serve Pepsi drinks at their outlets and thus, an increase in the sales at KFC and Pizza Hut outlets as aresult of AMP activities would lead to a corresponding increase in the sales of Pepsi.

B. Assessee submitted that the doctrine merely requires an identity between the contributors and beneficiaries and it does not contemplate that each member should contribute to the common fund or that the benefits must be derived by the beneficiaries in the same manner or to the same extent.

6. Revenue’s Arguments

(a) The moment a non­member joins the common pool of funds created for the benefit of the contributors, the taint of commerciality begins and mutuality ceases to exist in the eyes of law.

(b) Further, assessee operated in contravention of the SIA approval as contributions were received from Pepsi, despite it not being a member of the brand fund.

7. Three tests laid down by the Hon’ble Courts for existence of mutuality are:

(a) Identity of the contributors to the fund and the recipients from the fund

(b) Treatment of the company, though incorporated as a mere entity for the convenience of the members and policy holders, in other words, as an instrument obedient to their mandate, and;

(c) Impossibility that contributors should derive profits from contributions made by themselves to a fund which could only be expended or returned to themselves

(The English and Scottish Joint Cooperative Wholesale Society Ltd. vs. CIT (AIR 1948 PC 142) and CIT vs Royal Western India Turf Club Ltd (AIR 1954 SC 85))

7.1Analysis of these tests for mutuality by the Hon’ble Court:

(a) The moment a transaction opens itself to non-­members, either in the contribution or the surplus, the uniformity of identity is impaired and the transaction assumes the taint of a commercial transaction.

(b) What is prohibited is the infusion of a participant in the transaction who does not become a ‘member’ of the common fund, at par with other members, and yet participates either in the contribution or surpluswithout subjecting itself to mutual rights and obligations.

(c) The theory of completeness of identity presupposes the contributors and participators to be two separate classes, but there is oneness or equality in the matter of sharing of surplus/profits. This is to ensure that there is no interference of any alien commercial entity in the transaction.

(d) The mutuality and non-profiteering character of a concern are to be determined in light of its actual working structure and the factum of corporation or incorporation or the form in which it is clothed is immaterial.

(e) That members of a financial concern exercise mutual control over its management without the scope of prejudicial exercise of power by one class of members over the others is the quintessence for the existence of a mutual concern. The word “mutual” offers guidance to this effect. Literally understood, the word “mutual” points towards reciprocity and a mutual arrangement is one in which the members/parties have reciprocal rights or understanding or arrangement. An arrangement wherein one member is subjected to the absolute discretion of another, in such a manner that the entire liability may fall upon one whereas benefits are reaped by all, is antithesis to the mutual character in the eyes of law.

(f) The doctrine of mutuality, in principle, entails that there should not be any profit earning motive, either directly or indirectly.

8. The Observations of the Court while holding that the Principle of Mutuality Fails in the present case are as follows:

(a) Pepsi Foods Ltd. is not a franchisee, thus it is not a member of the mutual concern and cannot participate in the surplus. These two are mandatory ingredients to sustain the principle of mutuality, which in the present case have not been fulfilled.

(b) The Tripartite Agreement requires the Assessee to constitute a separate Brand Fund for each franchisee. Since no Brand Fund, has been constituted for Pepsi Foods Ltd., it does not become a part of the purported mutual arrangement so as to qualify as a beneficiary of the mutual operations. Further, any amount received by the assessee company to be treated as an advertising contribution, it must be paid by a franchisee. Thus, the amounts received from Pepsi Foods Ltd. cannot be viewed as advertising contributions “from a member of the mutual undertaking.

(c) The assessee is realizing money both from the members as well as non­members in the course of the same activity carried on by it, thus relying on the ratio in Royal Western   India Turf Club Ltd. (supra) the Court held such operations to be antithetical to mutuality.

(d) Further the argument of the assessee that the Pepsi Foods Ltd. does benefit from the contracts with franchisee is futile because any remote or indirect benefit reaped by Pepsi Foods Ltd., cannot be said to be in lieu of it being a member of the purported mutual concern and therefore, cannot be used to fill the missing links in the chain of mutuality.

(e) The exclusive contract between the franchisees and Pepsi Foods Ltd. stands on an independent footing and YRIPL as well as the assessee company are not responsible for   implementation of that contract.

(f) As per the terms of the SIA approval there was a pre-requirement that, YRIPL and franchisees were equally obligated to make contribution of a fixed percentage to the Assessee. However, drifting from this mandate, the Tripartite Agreement made it discretionary upon YRIPL to contribute to the common pool, thereby putting it at a higher pedestal than the franchisees. Further, the management of the Assessee was under full and absolute control of YRIPL and also the participation of the franchisees in the management of the assessee was again subject to approval by YRIPL.

(g) The contention of Assessee that it is not mandatory for every member of the mutual concern to contribute to the common pool is not tenable as it is no doubt true that an obligation to pay may or may not be there, but in the same breath, it is equally true that an overriding discretion of one member over others cannot be sustained, in order to preserve the real essence of mutuality wherein members contribute for the mutual benefit of all and not of one at the cost of others.

(h) The Court made a note of the clause from the agreement and observed that the franchisees do not enjoy any “entitlement” or “right” on the surplus remaining after the operations have been carried out.

(i) In the present case, even if any surplus is remaining in a given assessment year, it is   unlikely to reduce the liability of the franchisees in the following year as their liability to the extent of 5% is fixed and non­negotiable, irrespective of whether any funds are surplus in the previous year. The only entity that could derive any benefit from the surplus funds is YRIPL, i.e. the parent company. This is antithetical to the third test of mutuality.

(j) Assessee was not under any specific obligation of spending the amounts received by way of contributions for the benefit of the contributors. Thus, the Assessee has defied the conditions of SIA approval and has acted in contravention of the terms of approval. Further, the assessee company was formed to manage business on behalf of the holding company. In its true form, it was not contemplated as a non­business concern because operations integral to the functioning of a business were entrusted to it.

[Note : The argument put forth on behalf of the assessee company regarding diversion of income and  non-accrual of same in the its hand was left open by the Court as miscellaneous application in respect of same is pending before ITAT)

9. To conclude, the important observations of the Court in the context of doctrine of mutuality are as follows:

(a) The Hon’ble Court observed that, in order to determine the breach in mutuality, the court is well within its powers to go beyond the periphery of the concern and undertake an examination akin to the lifting of the veil in order to discern the real nature thereof. There is a fine line of distinction between absence of obligation and presence of overriding discretion.

(b) The doctrine of mutuality bestows a special status to qualify for exemption from tax liability. It is a settled proposition of law that exemptions are to be put to strict interpretation. The Assessee having failed to fulfil the stipulations and to prove the existence of mutuality, the question of extending exemption from tax liability to the Assessee, that too at the cost of public exchequer, does not arise.

(c) Further, true nature of transactions need to examined in the light of the facts of each case.

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